Collateral Explained: What It Is & How It Works

Collateral is an asset or property that an individual or entity offers to a lender as security for a loan. It is used as a way to obtain a loan, acting as a protection against potential loss for the lender should the borrower defaultDebt DefaultA debt default happens when a borrower fails to pay his or her loan at the time it is due. The time a default happens varies, depending on the terms agreed upon by the creditor and the borrower. Some loans default after missing one payment, while others default only after three or more payments are missed. in his payments. In such an event, the collateral becomes the property of the lender to compensate for the unreturned borrowed money.

For example, if a person wants to take out a loan from the bankRetail Bank TypesBroadly speaking, there are three main retail bank types. They are commercial banks, credit unions, and certain investment funds that offer retail banking services. All three work toward providing similar banking services. These include checking accounts, savings accounts, mortgages, debit cards, credit cards, and personal loans., he may use his car or the title of a piece of property as collateral. If he fails to repay the loan, the collateral may be seized by the bank, based on the two parties’ agreement. If the borrower has finished paying back his loan, then the collateral is returned to his possession.

Types of Collateral

In order to be able to take out a loan successfully, every business owner or individual should know the different types of collateral that can be used when borrowing.

1. Real estate

The most common type of collateral used by borrowers is real estateReal EstateReal estate is real property that consists of land and improvements, which include buildings, fixtures, roads, structures, and utility systems. Property rights give a title of ownership to the land, improvements, and natural resources such as minerals, plants, animals, water, etc., such as one’s home or a parcel of land. Such properties come with a high value and low depreciation. However, it can also be risky because if the property is sequestered due to a default, it cannot any longer be taken back.

2. Cash secured loan

Cash is another common type of collateral because it works very simply. An individual can take a loan from the bank where he maintains active accounts, and in the event of a default, the bank can liquidate his accounts in order to recoup the borrowed money.

3. Inventory financing

This involves inventoryInventoryInventory is a current asset account found on the balance sheet, consisting of all raw materials, work-in-progress, and finished goods that a that serves as the collateral for a loan. Should a default happen, the items listed in the inventory can be sold by the lender to recoup its loss.

4. Invoice collateral

Invoices are one of the types of collateral used by small businesses, wherein invoices to customers of the business that are still outstanding – unpaid – are used as collateral.

5. Blanket liens

This involves the use of a lien, which is a legal claim allowing a lender to dispose of the assets of a business that is in default on a loan.

Borrowing without Collateral

Not all loans require collateral, especially if the borrower doesn’t have any property to offer. In such a case, there are several ways to borrow money, including:

1. Unsecured loans

From the name itself, unsecured loans don’t give the lender any form of assurance or protection that the money will be returned. However, they usually involve relatively smaller amounts than what might be loaned against collateral. Examples of unsecured loans include credit card debts.

2. Online loans

With the advancement of technology, there are many more ways to get a loan. In fact, people can now obtain online loans that don’t require collateral and are often approved quickly. After filling out an application form, the lender will let the applicant know if he or she is approved, how much the loan amount is, the interest rate, and how the payments are supposed to be made.

3. Using a co-maker or co-signer

These types of loans don’t require property for collateral. Instead, another individual besides the borrower co-signs the loan. If the borrower defaults, the co-signer is obliged to pay the loan. Lenders prefer co-signers with a higher credit rating than the borrower. A co-signed loan is often one way an individual without established credit can begin to establish a credit history.

Collateral vs. Security

Collateral and security are two terms that often confuse people who think the terms are completely synonymous. In fact, the two concepts are different. The differences are explained below:

• Collateral is any property or asset that is given by a borrower to a lender in order to secure a loan. It serves as an assurance that the lender will not suffer a significant loss. Securities, on the other hand, refer specifically to financial assets (such as stock shares) that are used as collateral. Using securities when taking out a loan is called securities-based lending.
• Collateral can be the title of a parcel of land, a car, or a house and lot, while securities are things such as bonds, futures, swaps, optionsOptions: Calls and PutsAn option is a derivative contract that gives the holder the right, but not the obligation, to buy or sell an asset by a certain date at a specified price., and stocks.
• Collateral, or at least the ownership title to it, stays with the lender throughout the time the borrower is paying the loan. Securities, on the other hand, allow the borrower to benefit from both the loan and the securities portfolio even while the loan is still being paid back because the securities portfolio remains under the borrower’s control. However, the lender assumes a greater risk because the value of the securities may fluctuate substantially.

Additional Resources

Thank you for reading CFI’s explanation of collateral. CFI is the official provider of the global Financial Modeling & Valuation Analyst (FMVA)™Become a Certified Financial Modeling & Valuation Analyst (FMVA)®CFI's Financial Modeling and Valuation Analyst (FMVA)® certification will help you gain the confidence you need in your finance career. Enroll today! certification program, designed to help anyone become a world-class financial analyst. To keep advancing your career, the additional CFI resources below will be useful:

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